Although global bond funds have taken a huge hit, as central banks have raised interest rates repeatedly to ward off inflation, the big question on many people’s minds is, are the rate hikes coming to an end? After all, didn’t Jerome Powell, head of the trend-setting Federal Reserve Board hint last month that future increases could be smaller?
“We do think that we are getting close to the end of this rate-hiking cycle,” says Chris Chapman, senior portfolio manager, and co-head of global multi-sector fixed income at Boston-based Manulife Investment Management, and a member of the team that oversees the 5-star rated $9.2 billion Manulife Strategic Income F. “This has been a pretty aggressive cycle globally, across developed markets, as well as emerging markets. While central banks are communicating that there may be a few more rate hikes to come, they are certainly reaching the point where they are reducing the pace of those hikes. From the perspective of what the market has been pricing in, from our view, it’s been fully priced for what is left to come.”
Further Rate Hikes Priced In
Chapman argues that central banks are approaching the point where they may pause and start to see the impact of the series of rate hikes. “The Fed has commented that at this point you have to take into account how much tightening has been done. There are lags on the effect of economic activity,” says Chapman, who joined Manulife in 2005, after earning a MS in finance from Boston College in 2003. His 13-person team oversees an aggregate of US$23.5 billion in assets. “The Bank of Canada, for its part, has reduced the hikes from 75 basis points (bps) to 50. They need to start to see the impact of further rate hikes. This has been a similar theme in places like Australia and Norway as well. There is a lag effect, so it does take some time for the impact to flow through. We believe the bulk of the pain has been felt. On the whole, we are very positive about the outlook for fixed income.”
Given that bond yields are considerably higher than eight or nine months ago, Chapman argues that it is a good time to lock in those yields and start reaping capital gains as rates slowly ease back down. “Fixed income actually generates income now. You don’t have to take as much risk to generate those yields. In general, we have also increased duration a little bit. There is still a lot of volatility to be seen in interest rates. So, we haven’t maxed the duration out yet.”
Time to Roll Out the Duration
Currently, the fund’s duration is close to five years. In contrast, the duration for the benchmark Bloomberg Multiverse Total Return Index (C$) is 6.5 years. “We are benchmark-aware, but consider ourselves benchmark-agnostic,” Chapman adds. “We think more about total return potential, versus total risk. For our mandate, historically, we have been around the two to six-year duration range.”
Making a call on where interest rates may be next year, or even within a short-term horizon, is very difficult. Yet Chapman is upbeat about the future. “We are confident that rates will be lower, particularly at the longer end. Front-end rates will likely be a little lower, but they may be supported at the front-end, only because central banks may be hesitant to cut rates quickly,” says Chapman, noting that the yield curve may be moderately inverted. “But if we are right about this view of slower inflation, and slower growth, the longer end of the yield curve will probably start to price that in more quickly. Right now, the market is expecting just under a 5% Fed funds rate by the early part of 2023, and it is expecting rate cuts in the second half of the year. In the same vein, the market is expecting a Bank of Canada peak rate of 4.25% by the early part of next year. And it’s pricing in over 50 bps in cuts.”
Year-to-date (Nov. 28) Manulife Strategic Income F has returned -9.11%, versus -9.62% for the Global Fixed Income category. On a five- and 10-year basis, the fund has been a top quartile performer and returned an annualized 0.76% and 3.41%, respectively. In contrast, the category returned an annualized -0.53% and 1.14% for the same periods.
“2022 has been a very tough year,” observes Chapman, “But the positive outcome of a year like this is that we have an environment where forward-looking return potential looks pretty compelling. You don’t have to push yourself that far out on the risk spectrum to generate attractive yields.” Chapman shares duties with Dan Janis III, head of global multi-sector fixed income, Thomas C. Goggins, senior portfolio manager on the global multi-sector fixed income team and Kisoo Park, portfolio manager on the global multi-sector fixed income team.
“The underlying yield in our portfolio is the highest it’s been in over 10 years,” says Chapman, “And arguably, we are taking less risk to get that. In fact, our average credit quality in the portfolio has been increasing year-to-date, while the yield has been moving higher. As a starting point, you are actually earning some income.” Currently, the distribution yield is 3%, although the so-called underlying yield-to-worst (the lowest possible yield), is close to 6%. Conversely, the yield-to-worst at the start of the year was 2%.
Fixed Income Risks Still Exist
Still, Chapman notes a few risks on the fixed income horizon: China’s COVID policy may be easing in 2023 but it could take some time to be implemented. “China is a big driver of the global economy. We have to watch how this plays out.” Second, Europe’s energy demands need watching. “If they do see further stress, it will impact countries differently. We have to watch for potential political developments there.” Third, lower-quality credits in the corporate space will need more monitoring in a slower-growth environment. “Default rates have been very low. It won’t be a surprise to see a bit of an uptick in defaults in CCC-rated names in the corporate space. And in the loan space, some issuers that have been loan-only have seen their funding costs rise dramatically. The types of issuers that have to come back to market to borrow will be doing so at much higher funding rates. We might want to watch that area as well.”
From a strategic viewpoint, while the team has increased the fund’s duration moderately, it has also increased exposure to global higher-quality fixed income. “On the flip side, however, we are being a little more cautious on corporate credit and reduced US high-yield bonds and bank loans. The floating rate component [of bank loans] is not as compelling now. But also on the credit side, given that they [bank loans] are rated below investment-grade, we have gone from a peak of nearly 10% of the portfolio at the beginning of the year to about 2.5% at the end of October.”
Preferred Bond Portfolio Blend
From an asset allocation perspective, about 52% of the portfolio is invested in corporate debt, of which 23% is held in investment-grade bonds and 19% in high-yield bonds. There is also 36% in sovereign bonds that are issued by the U.S., Australia, New Zealand and Norway, with smaller holdings in areas such as mortgage-backed securities (MBS). “While we may be cautious on some of the weaker areas of credit, in general, corporate bonds still offer some attractive opportunities,” says Chapman, noting the team has been raising the exposure to investment-grade bonds.
Meanwhile, the team has raised the exposure to US treasuries whose risk-return dynamics are attractive, as well as areas of the so-called securitized market comprised of mortgage bonds issued by US government agencies such as Fannie Mae and Freddie Mac. “Another area that’s attractive has been made up of credit-risk transfers, or CRTs. They are issued by Fannie Mae Freddie and Mac, but are not guaranteed. You take a little more credit risk, but you get pretty attractive yields, in exchange.”
Chapman notes that spreads have widened for the government agency securities. “The market has been pricing in expectations of Fed balance sheets unwinding. As for the CRTs, it’s been more supply-driven. But you have seen spreads on those widen more so than comparably-rated corporate bonds,” says Chapman, adding that commercial mortgage-backed securities (CMBS) such as single-asset, single-borrower securities have also found a place in the portfolio.
Inflation’s Easing
Looking ahead, Chapman notes that inflation, the source of much of the pain in holding global bonds, has been gradually subsiding. “Inflationary pressures are easing. As a result, central banks, which have been aggressively raising interest rates this year, will be close to the end of that rate-hiking cycle. And if we see a slowdown in global growth, which is what we expect, and we see a deceleration of inflation, we should see bond yields start to move lower,” observes Chapman. “With a starting point of income being a lot higher, and yields moving lower, this should be a driver for an environment that’s positive for fixed income returns going forward.”
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